Multiple Year Excess Roth IRA Contributions (Including current year)
This forum is a fantastic resource! I scrolled through prior discussions on the subject of excess Roth IRA contributions and reviewed Pub 590-A. I’d be very grateful for any feedback on my particular circumstance and required corrective action.
I am in my 40s and made excess contributions to my Roth IRA in 2012, 2016, 2017, 2018, 2019, and 2020. My MAGI will be above Roth IRA limits in 2021, preventing a roll-over for the 2020 excess contributions.
For 2012 & 2016-2019, my understanding is that I will pay an excise tax of 6% on the excess contributions for each year the amount remained in the account and I need to file a separate 5329 for each year. When the excess contributions are removed, my understanding is it will be counted as a non-taxable Roth distributions and require an 8606 in 2021. Is this all correct? Will I also pay a 10% early distribution penalty once the excess is withdrawn. Also, I’d like to confirm that I do not need to withdraw earnings that are attributable to the excess contributions.
For 2020, I understand that normal procedure is to remove the excess contributions and all earnings prior to the filling deadline to avoid a 6% penalty. Would this still result in a 10% early distribution penalty? Alternatively, since the returns for 2020 were 34%, would it be smarter to file a 5329, remove the 2020 excess contribution, and pay a one-year 6% excise tax in order to retain the earnings in the Roth IRA?
Finally, my understanding is that earnings accrued from the excess contributions in 2021 (prior to 2020 filing deadline) are considered “gapped” and will not be penalized following corrective action. Is this accurate?
Thank you for your insights, recommendations, and corrections to my lay person understanding!
Permalink Submitted by Alan - IRA critic on Thu, 2021-02-11 17:09
The bulk of your observations are correct. Start with the 2012 5329, and complete one for each year since because excess contributions are cumulative. The 5329 will also reflect any year in which you were eligible and did not contribute (2013-2015) and will apply the 2012 excess to any of those years. This is known as “absorption” of the excess. The 5329 will also credit any early distributions you took in any of those years to reduce your excess amount. This is all automatic if you complete the 5329 forms correctly. If your excess is not reduced by either of these situations, it will grow every year and the excise taxes of 6% will be ever higher.
You do still have flexibility with the 2020 excess, to either remove it and pay tax and penalty on the 34% gains, or to NOT remove the excess with earnings before 10/15. If you take out just your excess amount for 2020, you wlll owe the 6% on the 2020 contribution (it will be added to the excess remaining after 2019), but you avoid tax and penalty on the earnings. You can calculate which option for the 2020 excess is best, but if you do not have a TIRA account another option is to recharacterize the 2020 Roth excess as a TIRA contribution, and then convert the recharacterized contribution back to Roth (aka back door Roth contribution). You would owe tax on the amount of gain when you convert, but no penalty, and both the contribution and the gains will stay in your Roth via conversion. So you might have 3 options for the 2020 contribution (removal with gains, removal without gains, and recharacterization and conversion. Removal with gains when the gain is 34% is likely your worst option.
Not sure I understand your last question. If you remove the 2020 excess with earnings you will owe tax and penalty on the earnings on your 2020 return, with earnings calculated right up to the date of the removal in 2021 (no “gap period” for IRAs). If you leave the 2021 excess in the Roth to substitute the excise tax for removal with earnings, you will be treating the 2020 excess just like all the earlier ones. That means you would add up all the excess contributions back to 2021, and request a distribution of that total, which includes your 2020 excess. This distribution should be requested late in the year, probably November, to allow more time for tax free gains on the entire amount. You would report this distribution for income taxes on Form 8606, but since it will be allocated to regular Roth contributions, it will be tax free. A final 5329 for 2021 will record the total distribution and will reduce your excess to 0. You will not owe any excise taxes for 2021 since you will have eliminated all the prior excess contributions before year end.